What It Is:

A prospectus is a legal document used by companies that are offering securities for sale.
 
For mutual funds, a prospectus describes the fund's strategies, the manager's background, the fund's fee structure, and provides a fund's financials statements.

How It Works/Example:

To get an idea of the role of the prospectus, let's assume Company XYZ is pursuing an IPO. Before launching the IPO, Company XYZ must first file a registration statement, which discloses all material information about the company, with the SEC. Part of the registration statement is the prospectus, which must be provided to all purchasers of the new issue. The prospectus contains much of the same information included in the registration statement, but without the supporting documentation. The registration statement must contain:

• A description of the business and how the proceeds from the IPO will be used

• The company's capitalization

• Legal proceedings

• The names and addresses of the company's officers and directors, their salaries, and a five-year history of each individual

• The amount of securities owned by the officers and directors, as well as a list of stockholders who own more than 10% of the company

The "Cooling Off" Period
After Company XYZ files the registration statement with the SEC for review, the cooling-off period begins. During this 20-day period, securities brokers can discuss the new issue with clients, but the only information about the offering that can be distributed is the preliminary prospectus.
 
The Preliminary Prospectus
The preliminary prospectus declares that the registration statement has been filed with the SEC but is not yet effective. This document contains the same information that will be found in the final prospectus with the exception of the offering price, commissions, the underwriting spread, dealer discounts and other related financial information. The preliminary prospectus is also known as a red herring because the legend on the cover is printed in red ink.
 
The Final Prospectus
When the registration statement becomes effective, Company XYZ will amend the preliminary prospectus to add such important information as the offering price and the underwriting spread. The final prospectus must contain:

• Description of the offering

• History of the business

• Description of management

• Price

• Date

• Selling discounts

• Use of proceeds

• Description of the underwriting

• Financial information

• Risks to buyers

• Legal opinion regarding the formation of the company

• SEC disclaimer

When the final prospectus is released, brokers can take orders from those clients who indicated an interest during the cooling-off period. A copy of the final prospectus must precede or accompany all sales confirmations.
 
The SEC Review
The Securities and Exchange Commission (SEC) regulates the contents and uses of the prospectus. Specifically, Regulation S-K gives specific instruction about what must be included in a prospectus. The SEC reviews each prospectus to ensure that it contains all necessary material facts, but it does not guarantee the accuracy of the disclosures. The agency does not approve the issue, but simply clears it for distribution. The SEC cannot prevent an IPO based on the quality of the offering, but it can require the issuer to disclose all material facts about the offering and the company.

Why It Matters:

The role of the prospectus is the make investors aware of the risks of an investment. Without this information, they would essentially have to make investments "sight unseen." This disclosure also protects the company from claims that it did not fully disclose enough information about itself or the securities in question.